Month: January 2011

According to Paul Krugman, we know that the growth estimates of the naughties are close to accurate because:

On the financial side, the point is that we measure growth by output of final goods and services, and fancy finance is an intermediate good; so if you think Wall Street was wasting resources, that just says that more of the actual growth was created by manufacturers etc., and less by Goldman Sachs, than previously estimated.

This just shows how little economists have tried to understand the nature of recent financial innovations. Wall Street can now create synthetic assets. That’s what a synthetic CDO is — it goes on someone’s balance sheet as an asset and there’s no requirement in accounting conventions that it go on somebody else’s balance sheet as a countervailing liability. AIG is just an illustration of how the accounting for such CDOs takes place.

In an environment where Wall Street can fabricate assets that enter into financial accounts in this way, it’s not realistic to claim that “fancy finance is just an intermediate good”. That used to be true in the good old days, when there was no reason to believe that the CDS contracts underlying synthetic CDOs would be enforceable contracts, but after the CFMA of 2000 (and other changes in the law), that isn’t true anymore.

For this reason, the economic assumptions underlying analyses like Krugman’s and Steindel’s do not reflect reality — and in fact they function as a blinder that prevents these economists from seeing and understanding what’s actually going on. By assuming that financial institutions can’t do what they did do, economists hobble their understanding of the nature of the current economic malaise.

Pers Sjoberg and Susan Hinko of TriOptima argued in Financial Times this week that OTC derivative markets aren’t liquid enough to be subject to real-time transparency requirements. But what does liquidity have to do with the social benefits of price transparency?

The correct comparison is not futures or option markets, but other illiquid markets like the corporate bond market. And it’s far from clear that real-time transparency has been detrimental to the corporate bond market — in fact, the most recent news has been that the corporate bond market is thriving.

The authors argue:

[In] highly-liquid, standardised markets, real-time reporting and price transparency are meaningful concepts. When these concepts are applied to the OTC markets, adjustments should be made, especially given the fact that many of these low-frequency transactions have large notionals and need to be hedged discreetly to minimise hedging costs.

The whole goal of price transparency is that it should be impossible for anybody to “hedge discreetly.” That’s the point. Every transaction shows up in the market price. If I do a bond transaction sequentially for two different accounts, I’m likely to see a price movement from one transaction to the next — and I trade in very small quantities. But this is simply the inherent nature of trading on a functional market where my earlier purchase (which was completely unpredictable before I sent it in) shows up as having a price effect after it has been made public. Price movements, like this, are the very purpose of transparent markets.

The authors continue:

However it is important for the new rules to reflect the realities of the market so regulators and the public have access to meaningful information. Intra-day reporting will place systems and cost burdens on institutions already restructuring to meet the demands of new legislation and regulation, and will not yield significant results to the public.

I don’t understand why purchases like my first purchase of an illiquid bond are classified by the authors as not “meaningful information.” That’s a decision that the dealers on the market make when they post their bids and offers. If a transaction is not meaningful to them, it will not shift the price, and, if it is meaningful to them, it will.

We can all understand that it is more beneficial to financial institutions for them to be able to trade with more information than the rest of us, but it is far from clear that protecting their intra-day information is in the public’s interests. If the only costs are structural, because financial institutions will have to set up real-time reporting systems, it seems to me to be in the public’s interest to create a standard that says that such systems should be set up for just about everything that financial institutions trade. Thus, when regulators want real-time reporting of a new product, it should take the financial institutions days, not weeks, months or years to provide.

We live in a society where every pack of gum is bar-coded and consumers can do cross-store price checks on their phones. Why has the financial industry chosen to maintain back office procedures that are practically medieval — even as they trade in multi-million dollar products?

After a turkey, successful construction of a 1100 piece K’nex rocket rollercoaster, many turkey sandwiches, several 10 person games of farkle, too many goodbyes and two “could have been much worse” flights, I can get back to the question of whether the causality in the CDO market ran from the “dumb” money to the low spreads or not.

What is missing from the argument that “dumb” money caused low spreads is an analysis of how synthetic assets (e.g. CDS on MBS and CDOs) affected the market. By definition a CDS has a short and a long side, so from a purely theoretic perspective it should have no effect on the price of the underlying — but this theoretic argument is based on a world without asymmetric information, so it is likely to be misleading (since one thing that’s pretty clear at this point is that the buyers and sellers of CDOs (and CDS via CDOs) definitely did not have similar information — the buyers were “dumb” because they relied on credit ratings).

Most participants in the market argue that the CDO market “needed” synthetic assets in order to meet the demand of the “dumb” money. But what this implies is that, in the absence of synthetics, spreads would have fallen even further and that, in the absence of synthetics, the demand would have extinguished itself as spreads fell to the level of treasuries and there was literally no point in buying CDOs because the yield advantage was completely gone. In other words, in the absence of synthetics, market forces would have worked to eliminate the “dumb” money demand for CDOs by eliminating the spread differential between Treasuries and CDOs entirely.

In other words, the role of synthetics was to artificially sustain the yield spread over Treasuries (small as it was) offered by CDOs. By keeping the yield spread up and delaying the function of market forces, synthetics kept the “dumb” money in the market and helped create a situation where the market collapsed abruptly (rather than slowly having the air pushed out of it by yield spreads that fell steadily to zero, discouraging demand in a natural manner).

In short, I think the “dumb” demand for CDOs was sustained for months and years, because synthetic assets created an artificial supply of CDO assets that kept yields at an artificially high level — in order to attract and sustain that demand.